2017 Outlook and Investment Themes

Outlook and Investment Themes

Benign baseline but zero room for complacency

Our cyclical baseline is for a continued global economic expansion, mostly supportive monetary and fiscal policies and broadly range-bound markets. Despite this benign baseline, there is little room for complacency as we are concerned about a number of risks, including the diminishing returns of monetary easing and the longer term consequences of rising populism.

Volatility likely on the rise in 2017

The recent bout of market volatility that followed the U.S election may be a guide to what lies ahead: occasional regime switches between periods of relative calm and periods of rising volatility. Going forward, central bank policy may not limit volatility to the extent it has over the past several years, and we believe that the greater uncertainty could translate into higher risk premia, warranting a more cautious portfolio positioning.

Policy shift: less monetary, more fiscal

The focus we have seen so far on monetary policy may change in favour of a greater balance of both monetary and fiscal policy.

Monetary Outlook

The Fed – A More Hawkish Stance: Going into the U.S. Presidential election, markets were pricing a very high likelihood of the Federal Reserve hiking the policy rate at its December meeting. Developments since then – especially the prospects for fiscal expansion that would reflate a fully employed U.S. economy – have only strengthened the case. We think the Fed will go ahead with the move in December, followed by one to two additional hikes in 2017.

The ECB – Tapering or not?: In Europe, the Central Bank’s enormous stimulus has strengthened Eurozone financial markets’ resiliency, but it has also made them dependent on ongoing stimulus to maintain stability. ECB’s decision on December 8th to prolong QE but at a lower level of €60bn a month sparked fears of tapering despite Draghi’s attempt to to downplay the importance of the move. Weaning markets off easy monetary policy will be a delicate exercise for the ECB and is a topic we think will gain prominence next year – and one that reinforces our long-term caution about investing in the Eurozone.

The BOJ – At A Crossroads: After 3.5 years of unprecedented unconventional monetary policy, the Bank of Japan appears to have hit its limit (or is at least approaching it). In September 2016, the BOJ made a policy “regime shift” from base-money targeting to yield-curve targeting. The BOJ from now on will no longer target a base-money increase but will target two specific interest rates: the overnight rate on part of excess reserves and the yield on the 10-year JGB. At PIMCO, we believe that the BOJ’s decision is evidence of its policy exhaustion. Going forward the BOJ will likely remain super-accommodative but will no longer be able to take the lead: it is sneaking into the back seat.

Fiscal Outlook

Developed Markets: In developed markets, fiscal policy could become a bigger source of positive surprises – mostly in the form of more stimulus – particularly in the aftermath of the U.S. election.

Japan: Japan has already announced a fiscal stimulus package amounting to around 1.5% of GDP spread out over the current and the next fiscal year.

UK: In the UK, following Brexit, the government has also indicated that policy will be eased, but details remain to be seen.

Europe: In the euro area, our base case includes a moderate fiscal stimulus for next year, but given that several large countries (Germany, France, Netherlands) will hold general elections next year, policy may well turn more expansionary than currently announced.

U.S.: Finally, in the U.S., we believe that the chance of a fiscal deal is relatively high following Trump’s election, though it would probably only be implemented in the 2018 fiscal year, which starts on 1 October 2017. However, expectations for more stimulus could lift confidence and thus encourage corporate and consumer spending well before implementation.

In general, more fiscal action can be a big deal for financial markets as it can shake up the newfound consensus that we are in secular stagnation, that central banks are the only game in town and that therefore rates will remain low forever. For this reason, we see a higher and more balanced inflation forecast and more rapid normalization of policy. Indeed, we expect inflation to pick up, as the labor market is tightening. However this inflation pick-up should be gradual, given the further potential strengthening of the U.S. dollar.

Emerging markets may be at a pivot point following the U.S. elections

Global conditions have generally trended toward more supportive of emerging markets in 2016 , including a more dovish Federal Reserve, lower-for-longer global central bank policies and an orderly rebalancing in China. However, Trump’s election, which raises the potential for fiscal stimulus in the U.S, a more hawkish Fed and protectionist trade policies, could create a more challenging landscape for EM. We believe differentiation within the EM asset class should persist, and that the winners and losers may vary dramatically depending on which of the potential combinations of U.S. monetary, trade and fiscal policy play out.

The good news is that EM assets face these complicated scenarios from a relatively attractive starting point. First, EM valuations remain attractive on a relative basis. And second, while investment flows have returned to EM and increased since February, the inflow has been modest compared to past cycles. As a result, with improving external balances and weak domestic demand in EM countries, the traditional threat to EM ‒ a sudden stop in capital flows resulting from a more hawkish Fed – appears reasonably contained.

Politics, main non-economic wild card for 2017

The outcomes of the Brexit vote and of the U.S elections have demonstrated that polls and political betting can get outcomes spectacularly wrong when the political landscape is shifting. So too could surprising outcomes in the upcoming elections in Germany and France next year. In the run-up to the 19th National Party Congress in China in the fourth quarter of 2017, uncertainty about the country’s future political, economic and military course is also likely to be elevated. Given the series of political risk events set to take place in 2017, there is plenty of room for temporary bouts of market volatility or even more permanent economic, policy and political regime shifts.

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